The projected revenue from a yet-to-be-introduced (much less enacted) cap and trade bill was built into President Obama's first budget presented to the Congress last month.

The Administration's plan calls for 100% auctioning of emissions allowances as part of a comprehensive program to reduce greenhouse gas emissions by 83% below 2005 levels by the year 2020. This is an early volley in what is expected to be a tough legislative battle to enact a cap on emissions by 2010.

The President's budget plan follows on the announcement last month by Senate Environment Committee Chairwoman Barbara Boxer (D-CA) of six principles to guide the development of climate change legislation in the U.S. Senate this year.

One of these principles is that the legislation should “ensure a level global playing field, by providing incentives for emission reductions and effective deterrents so that countries contribute their fair share to the international effort to combat global warming.”

This concern about a level playing field has been, and will continue to be, an essential feature of the debate on climate change legislation in the United States. But it is by no means unique to the United States — similar concerns have been raised in the EU and Australia, for instance.

What is common about the concerns raised in each region is the view that a national cap and trade system for greenhouse gases puts manufacturers within the system at a competitive disadvantage compared to manufacturers in other countries which are not subject to similar climate change regulations.

Most cap and trade proposals envision a system that works much like a carbon tax. Through the auctioning of allowances, a cap and trade system would impose an additional price for emitting greenhouse gases.

The intent of the program is that this additional cost is passed on to downstream consumers, creating incentives at each stage for producers and consumers to alter their behavior to reduce their exposure to these additional costs. Thus, market forces are used to find the lowest-cost approach to reducing greenhouse gas emissions.

But manufacturers in other countries who do not face these higher costs also gain a cost advantage.

If not addressed, this competitive disadvantage may ultimately lead to negative economic and environmental consequences. Domestic manufacturers may either go out of business, or move their production to an overseas location where greenhouse gas emissions costs are not imposed on manufacturers.

In either event, domestic employment is lost and the environmental benefit of the cap and trade system is undermined as carbon emissions increase in the unregulated jurisdiction. This is sometimes referred to as “carbon leakage.”

Addressing free-riders at the border

The competitiveness concern has long been an important part of the political debate over climate change in the United States.

In 1997, the United States Senate adopted by a vote of 95-0 the so-called Byrd-Hagel resolution, which expressed the view that the United States should not become a party to any international agreement on greenhouse gas emissions that did not include binding targets and timetables for developing as well as developed countries.

This position effectively precluded the active participation of the United States in the Kyoto Protocol because it contained no developing country obligations on greenhouse gas emissions controls.

This perspective remains very strong in the Congress today, and explains why the first climate change bill considered in the Senate last year provided that importers of energy intensive goods from countries that had not taken comparable action to reduce emissions would be required to purchase allowances as a condition of entry into the United States.

Similar provisions requiring imports from so-called “free-rider” countries to buy emissions allowances have appeared in other legislative proposals over the last year, and it is a good bet that some form of this proposal will make it into the bills introduced this year.

But there are a number of legitimate questions about whether this approach would be good policy, or would even serve the stated objective of "leveling the playing field" with industries in countries that are not internalizing the cost of greenhouse gas emissions in their energy prices.

For example, the proposed import allowance requirement has raised concerns that it would violate U.S. obligations under the World Trade Organization (WTO) and could lead to trade disputes or retaliation against U.S. exports to other markets.

The WTO imposes two basic rules of nondiscrimination that may be implicated. Under the “national treatment” principle, WTO members must ensure that any taxes or regulations imposed on imports will treat the imports “no less favorably” than they treat domestic products.

Under the “most-favored-nation” principle, WTO members are also prohibited from discriminating between imports from different countries of origin.
One way that an allowance requirement might discriminate in favor of domestic products is if the standard for determining the number of allowances required differs for imports and domestic goods.

Given the complexity in determining exactly how many tons of greenhouse gases are released in the production of each good (which may vary from firm to firm due to different production processes and energy sources), to date, most U.S. legislative proposals have provided that a national average emissions level would be calculated for each relevant product from each country.

While this would provide rough justice, it would also mean that more efficient, lower emitting plants in a country would be penalized vis-à-vis higher emitting plants in the same country.

Meanwhile, U.S. domestic producers would only be required to produce emissions allowances equal to their actual emissions, not some national average. This disparate treatment could permit the more efficient foreign plants to claim that they are, in fact, being accorded treatment less favorable than domestic production, in violation of the requirements of the WTO.

Moreover, most U.S. legislative proposals would require allowances only from those countries that have failed to take “comparable action” to reduce their greenhouse gas emissions. If, as a result of this rule, an allowance requirement is imposed on imports from some countries (e.g., China) but not others (e.g., the EU), on the basis that the EU has in fact taken comparable action while China has not, this may violate the most-favored-nation treatment requirement.

There is also a practical problem with the “comparable action” standard. There may be several ways in which a country could reduce its overall greenhouse gas emissions without ensuring a level playing field in the sectors viewed by U.S. industries as presenting the greatest competitive threat.

For instance, some countries might take action to preserve endangered forests that provide an offset to the emissions from their manufacturing sectors. From an environmental perspective, the overall reduction in emissions would be comparable, but this would not address the competitive advantage to a foreign industry that is allowed to continue to emit large amounts of carbon without facing higher costs.

Another practical problem with an import allowance requirement is that it would not offset the competitive disadvantage that a particular industry may face in export markets.

Given that many critical industries rely on exports for a significant percentage of their sales, this aspect of the competitiveness issue is simply too important to ignore. This is one reason why other jurisdictions, including the EU and Australia, have sought to address the competitiveness issue through another approach: allocation of free allowances to selected sectors.

The United States may well end up in the same place, although this means giving up President Obama's promise to auction 100% of allowances under his cap and trade scheme.